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Loyalty program operators are similar to insurance operations in the sense that they issue a claim “stamps” or “air miles” in exchange for cash upfront “float” (industry term “billings”). This cash or “float” can then be invested while the clients slowly (or never, see breakage) redeem their points or miles (industry term “redemptions”).
Ordered by increasing amount of uncertainty, money is earned through
Float from customers and the government (other people’s money²)
From day one the “billings” cash comes in with most of the revenue still unrecognized (except for a conservative breakage estimate), and offsetting “deferred liabilities” on the balance sheet. This means that almost no cash taxes are paid upfront.
In other words, this business uses other people’s money (clients) to earn extra money on the investment side, while deferring the cash taxes due on real loyalty earnings far into the future (after accounting for real breakage and devaluations down the road).
Powerful psychological biases working in favor of loyalty operator
I think there are some powerful psychological biases working in a loyalty card issuer’s advantage:
I now want to present a very interesting case study from the past, Buffett and Munger’s purchase of loyalty program Blue Chip Stamps (’70s business).
The main takeaway is that Blue Chip Stamps’ revenue (~’gross billings’) declined heftily in 10 years, while the float more or less kept up. Why?
In other words, permanently declining loyalty programs can still be valuable vehicles to compound investments in, using other people’s money.
Today, Aimia is trading at ~1.5 x current cash flow, with gross assets (excl. loyalty card liabilities) worth about 2x current share price because of the uncertainty surrounding the major partner Air Canada “AC” that is leaving in 2020 (10% of accumulation but 50% of redemption).
Aimia’s loyalty card “Aeroplan” is one of the biggest in Canada.
Network effects of being big
There is many-sided network effects involved.
What makes the program valuable?
Each category interacts, e.g. more redemption and accumulation partners makes the program more valuable for clients, more redemption partners and clients makes the program more valuable for accumulation partners, etc.
Lastly, it’s all about “the big data” nowadays. More # of each category makes Aeroplan’s data analytics more valuable because the number of interactions (data) increases faster than the individual amounts.
Case study investment case
It seems unlikely that management would not be able to manage its way through a “run on the bank” redemption before the 2020 expiry of AC by delaying customer redemptions through two control mechanisms that induce clients to delay and forget:
Given the network effects and switching hassle for customers, I do not believe Aeroplan is going away abruptly as the market seems to think (maybe slowly, but then again Blue Chip Stamps is an interesting case).
Disclaimer: no position*
*Not yet comfortable in the industry.
Comments are welcome.
MC & TC
In my previous contribution An exception to the no genuine value-add to society filter, I discussed a recent personal deviation from value investing.
This time I will expand on how reading Margin of Safety for a second time made me realize my personal context warrants more risk taking than generally advised in investment literature.
An imperative in investing is diversification. A portfolio of eight equal-sized stocks might be called risky “concentrated investing”.
Again, it is the context that is of great importance. For a wealthy investor holding close to 100% of net worth in stocks, I fully agree (the books are generally written by or for these types anyway). However, for investors that are invested across asset classes and/or benefit from large cash flows from relatively uncorrelated sources, the riskiness of this strategy is mitigated (e.g. an endowment with cash flows from forests, farms and real estate, or an individual that has a job and/or private business).
Seth Klarman highlights the advantage of having liquidity from high cash yielding positions in a downturn in his seminal book Margin of Safety:
The third reason long-term-oriented investors are interested in short-term price
fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.
Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others. Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value (discussed at greater length in chapter 10). Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends. The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase. Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well.
– Margin of Safety, chapter “At the root of a value-investment philosophy” paragraph “The Relevance of temporary price fluctuations”
It was only after investing on my own and reading this book a second time that I realized that my personal situation is similar to an investor with high cash flows from sources with relatively low correlation to the price of equity markets. Indeed, I derive significant cash flow from a job (rest assured that my employer is not an asset manager. Indeed, AM typically have a revenue ‘beta’ of ~2 to the stock market).
These sources of liquidity are not often discussed in investment books, but once I came to the above realization (in my 7th out of 10 years of investing!) I was embarrassed with my own lack of independent thinking.
Today I hold a lower cash balance in general as my “replenishment rate” is high. However, I do believe that having no cash is only “optimal” in theory. In practice, a small amount of cash can have the huge benefit of getting psychologically undamaged through a market correction, allowing oneself to rationally grasp the opportunities at hand.
Last year I started asking this:
What is the threshold of cash level that would actually make me happy when the market crashes?
My answer is 20% (taking into account my moderately high replenishment rate and the fact that I am a young investor, not an older disinvestor). Note that this is a theoretical question, as a certain M. Tyson said: Everybody has a plan until they get punched in the face. Likewise, the level that will truly feel good is probably a bit higher. Lastly, remember what Warren Buffett says about plummeting markets:
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
‘[S]mile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls— as investors gain.’ Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other.”
– Buffett in ’97 BRK chairman letter
Oddly, most newspapers and books are written for disinvestors (older and wealthier participants). We can guess to the reasons why:
In the last market correction (Feb ’16) I actually felt content, but that probably meant that my cash level was too high in practice (i.e. 30%). Today it is at 10%.
Some gold from Cialdini’s new book Pre-Suasion, para. “What is salient is important”:
[Kahneman] was once asked to specify the one scientific concept that, if appreciated properly, would most improve everyone’s understanding of the world. Although in response he provided a full five-hundred-word essay describing what he called “the focusing illusion,” his answer is neatly summarized in the essay’s title: “Nothing in life is as important as you think it is while you are thinking about it.”
What is salient is indeed important, Cialdini:
As the tenth anniversary of the terrorist attacks of September 11, 2001, approached, 9/11-related media stories peaked in the days immediately surrounding the anniversary date and then dropped off rapidly in the weeks thereafter. Surveys conducted during those times asked citizens to nominate two “especially important” events from the past seventy years. Two weeks prior to the anniversary, before the media blitz began in earnest, about 30 percent of respondents named 9/11. But as the anniversary drew closer, and the media treatment intensified, survey respondents started identifying 9/11 in increasing numbers—to a high of 65 percent. Two weeks later, though, after reportage had died down to earlier levels, once again only about 30 percent of the participants placed it among their two especially important events of the past seventy years. Clearly, the amount of news coverage can make a big difference in the perceived significance of an issue among observers as they are exposed to the coverage
Kahneman’s most important thing is worth repeating for investors:
Nothing in life is as important as you think it is while you are thinking about it.
TC and MC (the blog authors) discussed investing in Philly Shipyard (PHLY on Oslo Börse) a while back, and one counter-argument for not investing was that this company would not exist without the force and subsidies of the Jones Act. As such this company could not be labelled as a genuine value-add for society or customers.
Many value investors have mentioned they do not (generally) invest in companies that do not genuinely add value to their value chain or society. Usual suspects are cigarettes, gambling, time-share rentals etc. In different ways, these companies prey on humanity’s weaknesses (respectively addiction and ignorance). Another close to home company I like to use is Edenred (rearview mirror high and stable ROIC ‘great’ company that through regulation in France and Belgium enjoys operating in an oligopoly for a product that is fiscally advantaged but ultimately destroying value for society in TC’s humble opinion).
In different ways, these companies prey on humanity’s weaknesses.
However, I will explain why I have come to believe this rule is not (as) applicable to investments like Philly Shipyard ASA.
The great danger of investing in the above businesses is that they optically look like great companies from a rear-view mirror perspective (and near future perspective, with high and stable ROIC). Indeed, human weaknesses are time-invariant, or favorable (but questionable) regulations create a stable subsidized high ROIC, and these companies are generally valued as ‘quality’ by the market.
If the valuation multiples reflect quality this also means the investment only works out if the company is still flourishing 10 years from now (unless one is relying on future greater fools). The problem is that investors are very bad at predicting the future more than five years out. Once public opinion turns against these companies’ (the timing is highly uncertain), the valuation can tank towards liquidation value. I think I sketched an investment that has unknowable (immeasurable) uncertainty to the downside.
Value investors should prefer the inverse type of uncertainty. I believe immeasurable uncertainty vs risk is not often enough discussed, which is why I recommend having a quick read through The Dhandho Investor.
Why I made an exception and invested in Philly Shipyard
We have been following Philly Shipyard since Nov. ’16. Philly traded comfortably below liquidation value, and we found there was clarity that the Jones Act would not be repealed in the medium term (see also Trump’s slogan). Philly’s management seemed to have cared well for shareholder value in the past, and even a repeal of the Jones’ act could have accelerated the (liquidation) value realisation, locking a small profit or loss. In other words, the Jones Act regulation was not a large risk factor by virtue of the valuation. The upside was that there was a decent ~ >50% chance that this company could soon be valued on a going concern basis once a new shipbuilding contract would get signed (in that case it would be worth 2.5X – 4X).
Clearly it is always important to assess a company’s true value-add to stakeholders. However, I hope to have made a convincing argument that this factor’s weight in decision making is dependent on the context (“great company” / “cigar butt” valuation?). In case of cigar butt valuation, this factor is not on top of my checklist.
It is only through thinking about real-world case studies that I have found the courage to deviate from value investing dogma. Honestly, this is dramatic, as I only have one remaining personal example of a deviation worth sharing (in a next contribution).
For those that understand French, I very much recommend this excellent documentary on Vincent Bolloré. I found it to be quite unbiased, surprisingly.
Disclosure: long a bit of BOL (main thesis being that a full simplification is a catalyst for the unlocking of the NAV which is at ~2X the share price by virtue of the economic share count which stands at around 50% of the total share count, after accounting for the circular ownership loops. The timing is very unclear, but in the meantime NAV is compounded at a decent rate. The author did a very similar exercise as the highly recommended Muddy Waters analysis that came out just months after)
For everyone else, I have summarized the documentary:
I didn’t build my empire from one franc by being a passive investor, it’s not in my genes, I am an activist. – Vincent Bolloré at the Havas board meeting.
*Although Sarkozy is one of Vincent’s personal friends, the documentary shows an example where a Hollande visit to Africa allegedly helped Bolloré win a bid for a Cameroon port concession.